The Threat of a Eurozone Recession

Lucrezia Reichlin*

The eurozone may fall into a new recession by the end of this year, with potentially nasty political consequences. In addition to countering the cyclical slowdown, pro-European forces must urgently address the continent’s long-term structural economic problems.

LONDON – National statistical offices and international organizations are busy revising down their growth forecasts for Europe this year and next. Although they are doing the same for the rest of the world as well, and for China in particular, a slowdown in Europe may have nasty political consequences, in addition to economic costs.

Faced with this deteriorating outlook, eurozone policymakers should ask themselves three questions. The first is whether the eurozone slowdown is temporary, or persistent enough to lead to a possible recession. The second is what kind of recession might occur, and what policymakers can do to counter it. And the third is what Europe must do to address its longer-term structural economic problems.

Regarding the first question, GDP growth forecasts that look more than one quarter ahead are notoriously unreliable. We must therefore get a good grip on the current situation and analyze revisions to growth forecasts over the past year to judge the persistence of bad news.

My company, Now-Casting Economics, first detected a slowdown in the eurozone at the beginning of 2018. We now know that this deceleration started in the third quarter of 2017 and has affected all major eurozone economies, particularly Germany and Italy. This runs contrary to the widely held view of the eurozone as comprising a core of successful countries – especially Germany – and a debt-ridden, slow-growth periphery.

The German economy expanded by 2.2% in 2017, but growth probably slowed to 1.4% in 2018. Quarter-on-quarter growth turned negative in the third quarter of 2018 and is likely to have been close to zero in the final three months of the year. Data releases from Germany have consistently conveyed bad news. Initial signals from surveys, which are timely but volatile, have more recently been confirmed by hard data such as industrial orders, turnover, and new car registrations.

The trend is similar in Italy, where the problem is magnified by the country’s lower potential growth rate. This implies that a slowdown there has a higher chance of leading to a technical recession, normally defined as two consecutive quarters of negative GDP growth.

If this flow of bad news is confirmed – and the global slowdown, political uncertainty, and trade disputes suggest that it will be – then the eurozone may fall into a new recession by the end of 2019, just over five years after the end of the last one.

A recession, if it happens, will most likely be less severe economically and financially than that of 2008 or even 2011. This is mainly because the eurozone has a stronger financial sector and better crisis-management tools than it had a decade ago. Yet, politically, the next recession may be much more disruptive for the European project. The memory of the last crisis persists, and populism is on the rise across much of the continent. A new negative shock will therefore be highly divisive and politically poisonous.

Given these heightened risks, policymakers should avoid the mistakes of 2009, when eurozone governments – alone among the world’s big economies – pursued fiscal consolidation in the middle of the worst downturn since World War II. Unfortunately, the eurozone still lacks a common fiscal policy to help counter a slowdown or possible recession. Nonetheless, with sufficient political will, its members should be able to coordinate a response even within the constraints of the existing rules.

But neither fiscal nor monetary policies can reverse the slowdown in long-term trend growth that Europe – like other advanced economies – has been experiencing at least since the early years of the new millennium. This weaker long-term outlook reflects unfavorable demographics and a decline in productivity growth that stems from the uneven adoption of new technologies.

Slow trend growth is particularly problematic in the eurozone, because it makes cooperation among its members harder to achieve. Countries know that it is in their strategic interest to stick together, but doing so will become increasingly difficult if the European project continues to fail to deliver on its promise of economic growth and jobs.

The challenges that Europe faces today are different from those that confronted the world economy in the 1990s, when the eurozone was designed. Europe therefore needs a revamp. In particular, it needs a program of ideas on research and development, education, and social inclusion that could appeal to large parts of the population in all member countries.

The European Parliament elections are less than four months away. Pro-European forces need to campaign for a coordinated effort to counter the cyclical slowdown and– most importantly – for a cohesive and aggressive policy to address Europe’s long-term structural problems. Should they fail, the prospect of a parliament dominated by populist forces will become a reality. And this could mark the beginning of a slow process of European disintegration. /project-syndicate

*Lucrezia Reichlin, a former director of research at the European Central Bank, is Professor of Economics at the London Business School.